Productivity’s effect on your portfolio

At first blush, the Bureau of Labor Statistics’ quarterly productivity report may sound inconsequential. But it can be an indication of long-term portfolio performance.

Eric Freedman, Chief Investment Officer of U.S. Bank Wealth Management, explains that the report quantifies the output achieved by U.S. businesses over the past quarter. For those in public policy — and professional and institutional investors — productivity is of enormous consequence.

“Productivity measures how many goods or services a person or a machine can produce in a set period of time,” he explains. High productivity rates help the economy grow, which can lead to higher profits and wages, fuel value for equity holders and create longer, stronger business cycles without driving up inflation.

Thanks to productivity gains over the past 50 years, the world economy has expanded sixfold and average per capita income has almost tripled, according to a report from the research firm McKinsey Global Institute.

However, productivity gains have stalled. According to Cap Trust Advisors, productivity increased almost every year from immediately after World War II until 1974, and it has been positive every year since 1982. However, over these 70 years the increase in productivity has steadily declined. Analysts anticipate little upward movement anytime soon.

The rest of the world is facing similarly sluggish rates of long-term productivity growth, according to the Bureau of Labor Statistics’ “G7 Annual Change in Productivity” chart (which accompanies this article). That should be a concern for investors, Freedman says: “Because productivity is down and likely to remain subdued for some time, it will affect capital market returns.”

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The decline in productivity is occurring, in part, because of previous gains in other facets of efficiency, Freedman argues. Companies and suppliers eliminated waste via automation and by streamlining their supply chain, improving operational processes and taking advantage of more efficient technologies. Improvements in transportation infrastructure, connectivity, computing power and management strategies have also directly improved workers’ ability to be more productive. But at some point, there is only so much that can be done with these means. Freedman says, “It’s like an athlete who runs a four-minute mile. How much faster can he reasonably go? The human body is only capable of so much speed, and an economy has similar limitations.”

At the same time, widespread uncertainty regarding the global economy can make business owners hesitant to invest in innovation and capital upgrades. The McKinsey report notes that labor force growth is also slowing, which means productivity improvement depends on a smaller group of people to produce even more goods and services, Freedman points out.

Why Should Investors Care?

Unfortunately, many investors may not realize the connection between low rates of productivity and their investments, which might impair their ability to set realistic expectations for future rates of return.

Investors usually base their view of the future on what happened in the past, Freedman says. “But the returns we saw 10 years ago probably won’t be sustainable for the next decade. Growth in productivity is likely to remain stagnant for a while, and investors need to understand the implications.”

When productivity rates depress returns, investors have two suboptimal options: “They either can accept lower projected returns and adjust their anticipated portfolio growth accordingly, or they can take on more risk by investing in higher risk asset classes in an effort to sustain desired returns,” Freedman says.

Freedman’s team predicts that over the next five to seven years, low productivity will cause investors to allocate a greater percentage of their portfolios toward riskier asset classes in hopes of maintaining a high rate of return. These asset classes include stocks (which fluctuate in value in response to economic and business development), private equity (which are illiquid by nature and typically represent a long-term binding commitment) and real estate (which can fluctuate in value due to economic conditions, changes in interest rates and risks related to renting properties such as rental defaults).

Also, investors may allocate less to debt instruments, which are subject to risks such as changes in interest rates, credit quality and other factors. Risk is usually higher for longer-
term, lower-rated and nonrated debt.

Freedman adds that the risk to this strategy is that an aging population becomes more conservatively invested, but low expected returns in the bond market will likely push investors to riskier parts of the market.

Rather than take on more risk than comfortable, Freedman encourages investors to explore their biases about the marketplace and weigh riskier stocks against generally safer bonds. Given where the bond market now sits (all-time lows in yields) and the prevailing inflation risk (inflation is low by both historical standards and relative to where the Fed would like it to normalize), investors should reassess the role these asset classes may play in helping them meet their goals.

“Certain perceptions may still be true, but every client’s situation is unique,” he says. In some cases, adding more stocks or private equity and other alternative investment choices may be a good choice in times of declining productivity.

Knowledge is Power

The key to understanding how productivity rates affect your investments is education. Talk to your financial advisors, track market trends in relation to productivity rates and read all available information on the subject. “When you learn the jargon and understand how policy, economic trends and consumer trends work together, it demystifies capital markets,” Freedman says.

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Unraveling that mystery can help investors identify investments that fall in their risk comfort zone and, thus, help them make the right decisions at the right time. It can also help investors avoid making knee-jerk decisions in response to short-term fluctuations, economic events like the Brexit or political shifts like the recent U.S. election, he says.

Slow productivity growth is unlikely to change and may have a lasting impact on market returns. “No one can control these trends, but you can control how you respond,” Freedman says. “The more informed you are about productivity’s economic impact, the better your decision-making will be.”

AboutEric Freedman

Eric Freedman is the Chief Investment Officer of U.S. Bank Wealth Management. He oversees a team of professionals responsible for an investment management business that has grown to more than $130 billion in assets under management. He also directs investment strategy and policies on behalf of U.S. Bank.

Before joining U.S. Bank, Eric was Chief Investment Officer, Managing Director and Global Market Strategist for CAPTRUST Financial Advisors, where he helped grow the company to one of the nation’s largest Registered Investment Advisory (RIA) firms. Before that, he was a senior portfolio manager for Franklin Street Partners and a vice president in Goldman Sachs’ equity derivatives business.

Eric graduated with a B.S. in economics, magna cum laude, from Colgate University, where he was captain of the lacrosse team. He earned an M.B.A. in finance and management from the Wharton School at the University of Pennsylvania.

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